A New ‘Sound Money Indicator’

March 23, 2009 – The other day at lunch with a friend, we began talking about my Fear Index. He suggested that I give it a new name in order to more accurately convey the important message it offers. Namely, it numerically measures the soundness of the dollar.

Others have made similar suggestions for a variety of different reasons. For example, the Fear Index is also used for another indicator, which can be confusing. It is a nickname for the VIX, which is a measure of volatility in the stock market.

Anyway, I said to my friend that I would think about our luncheon discussion. It was indeed thought provoking, and thinking about the key points has led me to create the “Sound Money Indicator”. To explain it, I first need to provide some background information, starting with some basics.

The practice of “inflation adjusting” has become well-known. It attempts to equate in a consistent way the current cost of goods and services to the purchasing power of the dollar for the same goods and services at some previous point in time. It aims to offset the distortion in prices caused by inflation.

Clearly the dollar is not a consistent measure of purchasing power. But inflation adjusting is not a solution. There are two problems with inflation adjusting overlooked or ignored by nearly everyone.

First, the federal government has repeatedly changed the Consumer Price Index so that it no longer accurately measures the rate of inflation consistently. What’s even worse, the adjustments cause the CPI to significantly understate the real loss of purchasing power in the dollar, which has been made clear by John Williams of www.shadowstats.com.

The second problem is that inflation adjusting does not capture currency debasement. The debasement of currency is different from inflation.

When precious metal coins were used as currency, inflation would result if too many coins were circulated, even if they were gold and silver. There was, for example, a harmful precious metal inflation when the newly discovered riches of the New World were brought back to Spain within a short period of time.

In other words, regardless of the nature of the currency being used, inflation will be the result if too much new currency is introduced into commerce, regardless whether it is gold or silver coin in 16th century Spain or fiat dollars in the United States today.

The CPI attempts to measure this loss of purchasing power from inflation. What the CPI does not measure is ‘clipping coins’, which is the loss of precious metal in a coin said to contain a certain weight of metal.

If a one-ounce coin only has .99% of an ounce of gold, that coin has been ‘debased’. To put it into current-day terms, the coin is circulating with $955.80 of purchasing power (based on Friday’s closing rate of exchange between gold and the dollar), but only has $946.24 of gold content. Debased coinage is a much more subtle form of currency debauchment than inflation.

Debasement is particularly hard to grasp in today’s world in which currency is principally paper banknotes and book entries on a bank balance sheet. But regardless of the form it takes, we can nevertheless measure with the Fear Index how badly the dollar has been ‘clipped’. Here are the formula and calculations for the Fear Index as of February 27th:

Thus, as of February 27th, for every $100 of M3, which is the total quantity of dollar currency in circulation, the value of $1.69 is derived from the US Gold Reserve. The value of the remaining $98.31 is derived from the other assets in the Federal Reserve and the banks, namely, the loans and government paper they own.

The total quantity of currency, as reported in M3, determines inflation. The relative percentage weight of gold backing the dollar (which is the Fear Index) measures the dollar’s debasement.

So to get back to the point about ‘clipping’ the dollar, as the Fear Index declines, the dollar is being ‘clipped’. Just like a gold coin loses gold ‘content’ when it is clipped, a dollar in effect is losing gold content – i.e., the weight of gold that is ‘backing’ it – when the Fear Index declines.

Thus, to truly understand the debauchment of the dollar, use the Fear Index. It measures both inflation and debasement. It measures inflation because gold is a consistent measure of purchasing power. It measures ‘clipping’ because the Fear Index measures the weight of gold giving value to the dollar.

Here’s where the Sound Money Indicator (SMI) comes in. It portrays the dollar’s purchasing power by comparing it to when the dollar was as good as gold.

Please take a close look at the above chart of the SMI. It begins in January 1934, which marks the date when Franklin Roosevelt officially devalued the dollar by 69% by changing its metal content to 13.71 from 23.22 grains of fine gold. His action was a recognition that the dollar had been ‘clipped’ and was no longer worth 23.22 grains. As a consequence of the devaluation, the dollar’s rate of exchange to gold rose from $20.67 to $35 (there are 480 grains in a troy ounce).

Because the dollar was once again as good as gold – even though it now took $35 to exchange for one ounce – the result was that gold flowed into the US Treasury, increasing the weight of metal backing the dollar. Additionally, the dollar was still deflating from the economic and banking collapse during the Great Depression. The result was that the purchasing power of the dollar was rising, which can be seen on the above SMI chart.

For several years the purchasing power of the dollar continued to increase. The deflation and rising gold backing was making the dollar better currency than it was in 1934.

The SMI rose until the inflation induced by World War II caused the dollar to begin losing purchasing power. From its all-time high of $71 in 1940, the SMI began a protracted decline. Even though the weight of gold continued to grow during and after WW II, the increase in M3 caused the dollar to inflate and lose purchasing power.

The SMI fell to $35 in January 1945, meaning that the dollar in January 1945 was essentially no different than a dollar in January 1934. But it was also of lesser quality than the dollar that prevailed between those dates.

Once the $35 barrier was broken, the soundness of the dollar kept falling. The low was reached in 2001 at $2.15. The SMI has generally risen since then, and today stands at $4.03. The dollar today is only 11.5% of the 1934 dollar when measured in terms of gold.

So the Fear Index does not get a name change. Instead, it gets a new first cousin – the Sound Money Indicator. They contain similar but different messages. I think both are useful, assuming of course that the 261.5 million ounces of gold is still in Ft. Knox, but that’s a whole different story.